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Lesson summary: Price indices and inflation

AP.MACRO:
MEA‑1 (EU)
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MEA‑1.F (LO)
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MEA‑1.F.1 (EK)
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MEA‑1.F.2 (EK)
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MEA‑1.G (LO)
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MEA‑1.G.1 (EK)
In this lesson summary review and remind yourself of the key terms and calculations used in measuring inflation. Topics include the consumer price index (CPI), calculating the rate of inflation, the distinction between inflation, deflation, and disinflation, and the shortcomings of the CPI as a measure of the cost of living.

Lesson overview

You just got a raise! But wait: was that raise really a raise? The third of our three key macroeconomic indicators, the inflation rate, can help you figure that out. Inflation is an increase in the overall price level. The official inflation rate is tracked by calculating changes in a measure called the consumer price index (CPI). The CPI tracks changes in the cost of living over time. Like other economic measures it does a pretty good job of this. But it does have some limitations, such as substitution bias, which can overstate how much the cost of living really has changed.

Key Terms

Key TermDefinition
inflationa sustained increase in the overall price level in the economy, which reduces the purchasing power of a dollar
inflation ratethe pace at which the overall price level is increasing; this is the percentage increase in the price level from one period to the next.
deflationa sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative.
disinflationa slowing of the rate of inflation; for example if the rate of inflation is 5, percent in 2016 and 3, percent in 2017, there is still inflation in 2017.Prices are just not rising as fast as they were before.
aggregate price levela single number that summarizes all prices in an economy; price indices are frequently used to represent the aggregate price level.
price indexa measure that calculates the changing cost of purchasing a particular (and unchanging) combination of goods (called a “market basket”) each year; the consumer price index and the producer price index are examples.
consumer price index (CPI)an index that calculates the cost of a market basket of goods purchased by a typical family that lives in an urban area; the purpose of the CPI is to track changes in the cost of living over time.
market basketthe combination of goods that are used to calculate a price index; the goods stay the same from year to year.
base yeara reference year to which variables are compared; for example, the current CPI in the United States uses 1983 as its base year, so all values of the CPI compare the current to 1983.
real variablesvariables that are adjusted for the rate of inflation that represent the true value of something (such as real interest, real income, or real GDP); for example if your boss gives you a 10, percent raise, but the purchasing power of your money has decreased by 8, percent because of inflation, your raise is really only worth 2, percent.
nominal variablesvariables such as wages, income, or interest that have not been adjusted for the rate of inflation; you can think of nominal variables as the “sticker price.” The bank tells you they will pay you 3, percent interest, but the real interest rate that tells you what you are actually earning.
purchasing powerwhat can actually be bought with money; if you walk into a store with dollar sign, 10 and want to buy apples that cost dollar sign, 1 each, the purchasing power of your dollar sign, 10 is 10 apples; If the next day the price of apples increases to dollar sign, 2, you can only buy 5 apples, so the purchasing power of your dollar sign, 10 has decreased.
real interest ratethe interest rate earned that reflects the actual purchasing power of that interest; for example if a bank pays 3, percent interest, but there is 2, percent inflation, you really have only gained 1, percent interest because the purchasing power of your interest has decreased.

Key takeaways

The Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures the change in income a consumer needs to maintain the same standard of living over time. The CPI is meant to reflect changes in the cost of living for a typical urban household.
For example, suppose every household buys 2 bottles of cod liver oil, 10 loaves of bread, and 8 dog treats every week. A consumer price index tracks changes in the price of this unchanging collection of goods over time to measure changes in the cost of living for this household. Once the CPI is calculated for two years, we can to calculate the rate of inflation.

How the CPI is calculated

Let’s use the example above of the “basket of goods” consisting of 2 bottles of cod liver oil, 10 loaves of bread, and 8 dog food treats. Once the prices of the goods are calculated, the price of the basket in that year is compared to the price of the basket in some base year.

How the CPI is used to calculate the rate of inflation

The inflation rate is determined by calculating the percentage change in a price index (such as CPI or the GDP deflator). The inflation rate tells us the percentage by which the price level is changing from period to period.

Adjusting nominal variables into real variables

Real variables are nominal variables deflated by the price level. Examples of real variables are a real wage or a real interest rate. For instance, the sign at the bank says that they are paying 8, percent interest, but what are really earning?
If we want to find the real interest rate (the one that reflects what people are actually earning on money deposited in the bank), then we want to take away the effect of inflation. We do so because inflation reduces the purchasing power of the money deposited.
If the interest rate the bank gives us (the nominal interest rate) is 8, percent, but the rate of inflation is 5, percent, we are really earning 8, percent, minus, 5, percent, equals, 3, percent on the money that we put in the bank. Why? Because that is how much more we can buy when we take our money out after a year.

The shortcomings of CPI as a measure of the cost of living

Using the CPI as a measure of inflation has some shortcomings. That can cause the CPI to overstate the true inflation rate. For example,
substitution bias
causes the CPI to overstate increases in the cost of living. When the prices of goods go up, people will substitute other similar goods in place of the good that is now more expensive. But because the CPI assumes that the basket of goods never changes, it makes it appear that people always buy the same amount of a good that is now more expensive.
Another shortcoming of CPI is that it fails to account for changes in quality. For example, one of the reasons a 2013 Volvo Station Wagon costs more than a 1973 Volvo Station Wagon is that the newer model has things like seatbelts in the backseat, FM radio, and air conditioning. The CPI, however, treats these vehicles as identical, which overstates the true rate of inflation.

Key Equations

For any year, t:
CPIt=Cost of basket in year tCost of basket base year×100Inflation rate=CPInewCPIoldCPIold×100\begin{aligned} CPI_t &=\dfrac{\text{Cost of basket in year }t}{\text{Cost of basket base year}} \times100\\ \\ \text{Inflation rate} &= \dfrac{CPI_{new}-CPI_{old}}{CPI_{old}} \times 100 \end{aligned}

Common Misperceptions

  • If there is 2, percent inflation every year for five years, then after ten years the price level has gone up to 20, percent, right? No! Inflation compounds over time. For example, suppose a chicken coop costs dollar sign, 100 and there is 2, percent inflation, that means that after a year the chicken coop will cost dollar sign, 102. If inflation continues at 2, percent for another year, the dollar sign, 102 grows by 2, percent, not the original price. In fact, if there is 2, percent inflation every year for 10 years, the chicken coop will cost dollar sign, 121, point, 90, 21, point, 9, percent more than the original price.
  • The term “index” might sound strange, but an index is simply any measure that compares a value in one period to the value in a base year.
  • Another common misperception is that once we calculate the CPI, we have the rate of inflation between any two years. That is a necessary step, but it is not the final step. We must then use the CPI in both years to calculate the rate of inflation.
  • There are actually several different price indices used to calculate the rate of inflation. The CPI is the one that is used to calculate the official rate of inflation, which is why you’ll often hear it reported in the news.

Discussion Questions:

  • What are some reasons that the CPI might not capture the true rate of inflation?
  • How might changes in spending habits of households over a 20 year period change? How does this impact CPI as a measure of the cost of living?
  • The CPI in the nation of Montrose was 220 in 2016 and 200 in 2015. What is the rate of inflation between 2015 and 2016?

Want to join the conversation?

  • leafers seed style avatar for user Allan
    Discussion Question 1: Some reasons that the CPI might not capture the true rate of inflation are the substitution bias and the quality bias.

    Discussion Question 2: Households might substitute more expensive items for cheaper items. This does not impact CPI unless they change the basket of goods.

    Discussion Question 3: The rate of inflation is around 10%
    (3 votes)
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  • starky ultimate style avatar for user lqiming2
    Why we must use the CPI in both years to calculate the rate of inflation? Can we just use "inflation rate = (prices of goods in the current year - prices of goods in the base year)/ price of the goods in base year" to calculate the inflation rate?
    (3 votes)
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    • boggle blue style avatar for user Bryan
      You could. That would calculate the inflation rate going from the base year to the current year. Calculating percent change in the CPI from the base year to the current year will give u the same answer.
      (1 vote)
  • hopper cool style avatar for user Siddhant
    Since the prices of goods keep fluctuating over time, which prices are considered for CPI calculations.
    (1 vote)
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    • male robot donald style avatar for user Jeremy S
      All prices as part of the CPI calculation are based upon a set market basket. To calculate CPI, the current market basket price (of all goods within the market basket) is divided by the price of the market basket in the base year. Thus, the CPI is still grounded in base year prices from 1982-1984. However, the changing prices of goods found across the domestic economy is indicative of one problem of the CPI calculations because these calculations do not account for quality or quantity changes, or the change in preferences of certain goods through an increased variety of products.
      (1 vote)
  • blobby green style avatar for user bhold114
    If something like a gallon of milk was included in the market basket used to calculate CPI, would it be a specific brand used in the calculation, or an average of all available options for a gallon of milk with brands represented for the geographic area?
    (1 vote)
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    • area 52 green style avatar for user Eirian
      "How do US government statisticians measure the Consumer Price Index?
      First, they decide on a basket of goods that is representative of the purchases of the average household. This is done by using the Consumer Expenditure Survey, a national survey of about 7,000 households that provides detailed information on spending habits.

      Consumer expenditures are broken up into eight major groups which in turn are broken up into more than 200 individual item categories. For each of these 200 individual expenditure items, the BLS chooses several hundred very specific examples of that item and looks at the prices of those examples. The specific products and sizes and stores chosen are statistically selected to reflect what people buy and where they shop.

      The basket of goods in the CPI thus consists of about 80,000 products—several hundred specific products in over 200 broad-item categories. About one quarter of these 80,000 specific products are rotated out of the sample each year and replaced with a different set of products."
      (0 votes)